Tuesday, September 13, 2011

When are interest rates going to rise?..or are they?

We have had some economic troubles no doubt over the past few years but interest rates have been historically low throughout.  Even now, after the Fed has printed a 200% increase in the money supply in just two years a.k.a. Quantitative Easing (QE1, QE2), interest rates remain low.  Will they remain that way?  

There was essentially nobody who thought that housing prices would fall in the United States for any prolonged period of time, and any pullback in price was expected to be a minor adjustment.  That did not happen as we all know because there was no precedent in history to account for any severe drop in housing prices.  What we saw  was that home prices were effectively doubled from 2000 to 2006 while income was on average only up 2% over the same time period.  This imbalance was not sustainable.  If you look back at the economy over that period of time, economic growth in 2003/4 for example was largely due to home equity spending and rising home construction, with much of that spending being discretionary.

The mortgage industry had unique products such as ARM (adjustable rate mortgages) with a new twist of offering a low introductory interest rate which would allow people to buy a larger home than they could otherwise afford, and approving these loans with the full understanding that these people could not afford the higher rates that were coming once the introductory period was over.  Other "innovations" included Option ARM's which would allow you to make a principal plus interest, interest only, or even a partial interest payment!  The unpaid interest was added to the principal until the loan value reached a pre-determined figure such as 125% of the original loan amount.  At that point, you had to jump to the payment of full interest and principal of the larger loan amount....More than 4 out of every 5 people with such loans would take the lowest payment option and these loans had a 90% + default rate when things turned sour.

Further, mortgage professionals became more aggressive with the mandate to pump out the loan products.  As long as the loan was placed and approved by the underwriter, the loan was not their problem.  In fact, it appears that it was not typically a worry of the underwriters either because they wanted to package as many loans as possible into MBS's (mortgage backed securities), selling them in multi-million dollar bundles to big investors.  The underwriter collected their fee and didn't worry if the borrowers who took out the original mortgages could make consistent payments, or even make any payments at all to the buyers of the MBS's.  The investors who bought the MBS's considered these loans similar to government bonds but with higher interest rates payable.  Bond rating agencies such as Standard & Poor's and Moody's gave a AAA rating to many of these bond packages encouraging this positive view from the investors who bought them.  As the loans started to go bad, investors lost confidence and lost a lot of money, requiring the government to step in as a buyer of last resort for the MBS's to bolster investor confidence.  

The Fed has been printing huge amounts of money since 2009 as previously mentioned.  This has never happened before on this scale in the history of the USA.  The Fed has to figure out a way to substantially reduce this massive money supply to better reflect economic growth before inflation sets in but they can't do that right now because the economy is not strong enough to allow it.  Inflation goes up as a result of the buying power of the dollar going & demand.  Having a much bigger supply of an asset relative to demand for it makes it less valuable, and this applies to the dollar, so the real cause of inflation is an increase in the money supply substantially beyond what is needed for real economic growth.

The huge increases in money supply will stimulate the economy short term, but will ultimately cause inflation later.  I wanted to take a look at investor psychology for a moment, which does relate to what we are talking about in this article.  Take a look at the following chart.  The correlation is clear between Quantitative Easing (money printing by the Fed), and the S&P 500 Index after the big crash of 2008/9 in the stock market.  It certainly appears that the "bull market" that we have seen since the sharp about face in the market in early 2009 have been driven by the massive printing of money by the Fed.  If you have studied markets, it is clearly a bizarre turnaround from early 2009.  Bull market starts tend to be more gradual with some ups and downs and then a gradual rise in value.  That did not happen, and the market basically made a switch almost overnight from a bear to a bull market driven by the Quantitative Easing announcement.  Clearly the chart tells this correlation story brilliantly.

The problem with inflation is that it will drive interest rates up because lenders cannot afford to lend you money at say 5% when inflation is at say 8%.  This means they would be losing money, so they compensate by charging a higher interest rate than inflation because lenders are in the business of making money and not losing it.  The borrower now has to pay a higher interest rate which makes affordability an issue because they now can't afford to pay more for their next home than they would if interest rates were lower.  In fact, they may not be able to pay for their current home if a rise in interest rate happens.  Example.........An increase from 4% to 5% in interest would mean that the borrower could only afford a home that was 11% less than if interest were at 4%.  So the impact is rather large on affordability with a small interest rate change.

Based on the available information at hand it will probably make sense to lock in your lower interest rate soon, because rates are low now.  Try to get as long a term as you can for longer term protection against higher interest rates.  When higher interest rates do come (and everything points to that starting to happen within the next 2 to 3 years based on history), you will be protected from paying those higher rates for a longer period of time.  Keep an eye on interest rate announcements and if you want to take a longer wait and see attitude, see what the trend is and then make your decision.

In 1999, Ben Bernanke and other co-authors (Mishkin, Posen and Laubach) reviewed past world historical instances of large money supply increases and they determined there was a lag period of about two years between the large increase in money supply and the onset of noticeable inflation.  This onset can be delayed by a poor economy, or by the Fed paying interest to the banks on their excess reserves to keep them from lending that money (which the Fed is doing at this time).

Interest rates will be going up.  Although nobody knows for sure when that will happen, keeping an eye on what the economy and what the Fed is doing in conjunction with the understanding of what fuels inflation will help you make better investment and housing choices today and in the future.  Money can be made in any economy, but making the right decisions is key through proper understanding.

A brief note for Canadians who have been enjoying substantial growth in real estate asset values for more than a decade now.  Some large markets are experiencing growth at 4 times (or more) the rate of inflation.  It would be very prudent to make adjustments in your investing decisions.  As I have mentioned before in my blog, long periods of real estate price appreciation that we have seen in some big Canadian cities are not normal based on history.  In some cases, prices have been appreciating for double the normal cycle, and clearly the economy is not the driving factor but it's primarily foreign investment.  Watch your leverage if buying in those markets.  Affordability and income will be affected drastically if even marginal interest rate increases occur.  Plan to win rather than fail to plan.

Until next time, I wish you much prosperity.

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